Trading Secrets: One Rate to Rule Them All

Economics

Rather than listen to what prices are
saying, central banks prefer to talk. Asset
prices are told to levitate, interest rates
are commanded to kowtow, and product
markets are told to walk faster. The
happy result of all this orchestration
is supposed to be steady growth and
a stable financial system. However,
the precision with which central banks
direct the clouds is very much at odds
with the tumult of market realities.
Prices are continually ebbing and flowing
as preferences shift, as capacity and
demand seek to balance one another,
and as new information is injected into
the marketplace. Even were an august
body of central bankers able to
determine the “right” level for stocks,
bonds, real-estate, and inflation, the
answers would be wrong the moment
after they had been right. In other times
and places, central planners tied
themselves up in knots calculating
production schedules and setting prices
that could have been readily revealed by
a functioning market. Central planning
proved to be an utter failure not because
the planners weren’t smart, but because
no one is smart enough to know what is
or will become the mutating matrix of
desires that reside within the heads of
millions of consumers, savers,
borrowers, and investors. Monetary
policy is predicated on counting
everything that can be counted while
ignoring the individual preferences
that really count. Prices established
through the normal course “negotiation”
of buyers and sellers reflect real
preferences; any other price is an
artifice. Investors who are basing
their retirement expectations on
the supposed omniscience of central
bankers may want to think again.

Case in point Europe. Hoping to
stimulate something, the European
Cental Bank (ECB) has driven some
2.6 Trillion euros worth of sovereign
debt into negative yields. These negative
yields have slammed the euro, effectively
cutting the global price and wage of
everything and everybody in the
Eurozone (EZ). So, the ECB “gets”
the fact that wages and prices in the
EZ are uncompetitive. But rather than
grounding its policies in reality, the ECB
has used QE to contrive a fantastical rate
structure. Were markets allowed to
operate freely, the result would be that
EZ prices and wages would adjust lower
in search of proper market clearing levels. Rather than accept that
sometimes prices need to go down as
well as up, the ECB uses QE to arrest
necessary market price adjustments.
Why? Because the ECB, like their
brethren central bankers elsewhere
refuse to hear the markets and further
equate deflation with economic
annihilation. But, economic growth and
deflation have gone hand-in-hand before
(e.g., in the U.S. in the mid-1950s) and,
more to the point, the “theory” that says
consumers will just stop buying when
prices fall is belied by the everyday
experience of computers, smartphones,
airline travel, and gasoline. Deflation is
a price signal telling us that there is an
excess of capacity over demand. Sure,
demand can be temporarily boosted by
fiddling with interest rates; but sooner
or later rates have to return to market
levels. So the ECB is left with a choice:
let prices and wages fall to levels
commensurate with the productivity
of the European worker or indefinitely
enable the excess capacity problem
the market is trying to fix.

Where did central banks get the notion
that artificial interest rates can cure
fundamental economic maladies? If
the productivity of a workforce cannot
validate a wage rate, no amount of
cheap credit is going to alter that reality.
Europe is 19 countries, one low rate,
and yet Germany and Austria sit pretty
with unemployment at 5-6% while Spain
and Greece wallow in a depressionary
milieu. To argue that the ECB should
go on falsifying rates fearing that
deflation would make matters “worse”
in peripheral Europe, begs the question:
how much worse might it get? More to
the point, if growth were a function of
policy rates, how could unemployment
levels be so radically different within the
same monetary zone? Yet, Germany’s
relative prosperity is no mystery:
Germany’s constellation of labor and
capital is competitive in a way that
Greece’s are not. Hence, German
factories service their “fair share” of
global aggregate demand while factories
in Greece and Spain languish. Central
bankers can go on “manufacturing”
aggregate demand, but the simple truth
is that demand will be satisfied by the
efficient producer, not the
uncompetitive supplier.

Many draw a distinction between the
dysfunctions of Europe with the hope
and promise of central banking in the
New World. Yet, market principles work
precisely because they reflect universal
human realities. When the trumpets
blew for QE and zero rates at the Fed,
the supporters of such policies called
for a “recovery summer” in 2010, an
“exit strategy” in 2011, a 6.5%
unemployment “trigger” in 2012, a
“taper” in 2013, and maybe, just maybe
a rate hike in 2015. The Fed has become
a study in cognitive dissonance. On the
one hand, the Fed tells us that its
policies are working. On the other hand,
the Fed frets that after six years and
trillions in balance sheet expansion, the
policies aren’t working well enough to
get off the zero bound.

But aren’t lower rates better than higher,
you say? Aren’t they “stimulative” and
lead to better outcomes? In effect,
doesn’t the Fed know better than the
market how much and at what price
credit should flow? Such foundational
misunderstandings conflate the loanable
funds market (which the Fed controls)
with the market for real capital resources
(which marches to the beat of a market
drummer). Interest rates – like all
prices – are not arbitrary constructs.
Prices that are either too high or too low,
by definition, lead to suboptimal
outcomes. The Fed’s control over
loanable funds does not re-arrange
economic reality. The elasticity of actual
resources such as skilled labor, patents,
concrete, electricity, etc. is far lower than
the elasticity of electronic excess
reserves created by the Fed. Resources
do not simply expand because there are
more claims on those resources! And,
to use a scarce resource one way is to
preclude its use in another way. This
means that there are real opportunity
costs associated with all activities.
Pretending that scarce resources are
free for the taking only means that the
“rationing” of those resources ceases to
be based upon market precepts. Rather,
allocation preferentially shifts to those
sectors (e.g., housing) that Fed policies
favor. And, distorting resource allocation
hampers growth even as it encourages
a bull market in malinvestments.

While we may all hope that this global
experiment in extreme central banking
will end well, hope has never been a
great predicate for an investment. The
consequences of central bankers using
their One rate of Power to control
Planet Earth’s growth and inflation
may prove as rueful as that One ring
did in Middle-Earth.